Stock prices are “melting up” again. The S&P 500 is up a staggering 34% since the low about 5 weeks ago. The strong bounce is based on hopes for a speedy recovery from the COVID-19 outbreak and the worst economic downturn in generations. There is also little doubt that investors have become emboldened by the Federal Reserve’s commitment, which was reinforced this afternoon, to support asset prices and keep interest rates near zero. But setting aside the scientific/medical probabilities of eradicating COVID-19 in relatively short order, are investors right to be so hopeful about a speedy economic recovery? From where I sit, I can think of four good reasons why this massive rally should be viewed with a heavy dose of skepticism:
- The rally has been heavily dependent on a few very large companies as the weighting of the FANGs stocks (Facebook, Amazon, Netflix, Alphabet, and we include Microsoft) in the S&P 500 is now above 20%. In fact, an exchange-traded fund (ETF) that assigns equal weighting to all 500 companies in the S&P 500 has underperformed the S&P 500 by almost 9% over the past year. Such persistent narrow leadership can be a warning sign.
2. Low interest rates are not always good for stock valuations when they fall too low. The following chart, taken from an April 29, 2020, Credit Suisse piece by Jonathan Golub, shows that stock P/E ratios tend to be lower when rates fall below moderate levels. Golub says, “depressed yields tend to be a sign of weak economics or heightened uncertainty, putting downward pressure on P/E ratios.” Furthermore, a number of S&P 500 companies have already cut their dividends, which means that stocks may no longer be a good substitute for bonds for investors looking for stable income. According to an article in last week’s edition of Barron’s, “As of Friday afternoon, nine S&P 500 companies had suspended their dividends this month and about half a dozen others had announced decreases as part of the economic fallout from the coronavirus pandemic.”
3. The S&P 500 price-to-earnings ratio on next-twelve months’ earnings, at about 20.5x, is near a 20-year high, and we don’t even know what the ‘E’ is going to be yet!
4. Earnings estimates continue to plummet with no end in sight. The consensus S&P 500 estimate for 2020 earnings has now dropped over 30% from a high of about $194 in September, 2018, to the current $134.50. Please take note that earnings had already been falling consistently for 16 months before the arrival of COVID-19. Can anyone say with any degree of precision how low earnings may go in an environment of 30% unemployment and plummeting economic growth?
It’s fairly clear that investors are looking past the extreme short-term weakness in corporate earnings over the next year. That seems like a reasonable approach given the highly unusual nature of the economic shock caused by COVID-19. However, we still do not know with any degree of confidence: 1) the ultimate magnitude of the decline in corporate earnings related to this potentially short-lived recession; and 2) the pace of the recovery from this unprecedented economic downturn. It seems to me that fairly optimistic assumptions are now being baked into the market on both scores, and that gives me pause.